P1. Financial markets and Products

[Sha]

Hi David

Could you please clarify below doubts on financial markets
1. change in cost of carry as a source of basis risk:
How can change in interest rate increase the opportunity of holding the assets, so that cost of carry ad hence the basis of contract increases?
2. How is liquidity of an hedged asset inversely proportional to basis risk?
3.What is the difference between payoff and valuation of financial derivatives such as FRA

Thanks
Shalini

 

[David Harper CFA FRM]

Hi Sha, these are pretty wide open questions, I much prefer specific references because authors and contexts vary, but from a narrow FRM perspective (by which I mean, in this case John Hull):

• In Hull, the cost of carry model is: F(0) = S(0)*exp(cT) where c is the cost of carry and, for example in the case of a consumption commodity, c = r + u = riskfree rate + storage cost. The riskfree rate (r) is always in the model, for both consumption and investment commodities, because of the opportunity cost of cash. If we purchase a commodity today, we employ cash which has either an explicit cost (borrow) or an opportunity cost (can't collect interest on cash in the banks). So, the models always assume (keep in mind) that spot commodity purchases require cash. In this way, at a minimum, the forward price, F(0) increases with the riskfree rate (r) simply because the forward buyer does not need to commit the cash immediately. Basis = S(0) - F(t) or F(t) - S(0). A fluctuating (changing) interest rate, r, therefore causes F(t) to vary, which adds noise to our hedge. Another, IMO, would be the thy of normal backwardation: E[S(t)]*exp(r-k) = F(0); i.e., our ability to lower basis risk (i.e., hedge effectively) depends on a correct prediction of the relationship between the forward price and the expected FUTURE stock price (for example, if we predict perfectly, then basis changes are totally predictable such that we can perfectly hedge), but changes to the interest rates would interfere with our ability to anticipate EXPECTED changes to the basis
• Without going deep, our basic FRM concept is: there is a somewhat inevitable trade-off between liquidity and basis risk. To increase liquidity, the contract requires increasing degrees of standardization which implies a lack of customization ("tailoring") which, in turn implies greater basis risk. Our basic example is trading a forward contract (because it can be customized, basis risk should be lower; but the very customizations creates the uniqueness which makes the contract less liquid) versus a futures contract on an exchange (highly liquid due to standard specs but lack of customization means the exchange's commodity is unlikely to be same/highly similar to the underlying exposure).
• Payoff is a future outcome, typically a cash flow and typically unknown because it occurs in the future. "Payoff" is representative of risk measurement: stock option payoff charts are "distributions" of various possible future outcomes. In an FRA, we can still select an expected future outcome, and compute an expected future payoff (cash flow). "Valuation" is pricing and implies a point estimate and present value ("center of the distribution); related, it does not necessarily imply a cash flow. (for example, say you will receive $1.00 payoff in one year. that's a future cash flow payoff, but today's valuation is not cash). So, valuation tends to imply a single, present value. Thanks